The Securities and Exchange Commission’s Office of Compliance Inspections and Examinations (OCIE) issued a risk alert earlier this month from its national examination program warning investment advisers of the most common compliance deficiencies that OCIE found related to principal trading and agency cross transactions under the Investment Advisers Act of 1940 (the Adviser’s Act). As most compliance professionals know, a risk alert is often a precursor to aggressive enforcement action in a particular area and allows the Commission to tell advisers that they were warned. The takeaway: paying close attention to a risk alert is prudent.
The risk alert begins by reviewing adviser compliance requirements for principal trading and agency cross transactions with clients.
Principal Trading
Under Section 206(3) of the Adviser’s Act, an adviser acting as a principal for his or her own account cannot knowingly sell any security to a client or purchase any security from a client without disclosing to the client in writing before the completion of the transaction the capacity in which the adviser is acting and obtaining consent from the client for the transaction. The disclosure and consent requirements cannot be undertaken in blanket fashion. An adviser’s conflict of interest in this situation creates risk, so the SEC requires disclosure and consent on a transaction-by-transaction basis.1
Brokering Trades
Generally, Section 206(3) also bars an adviser from directly or indirectly brokering client securities transactions without disclosure of capacity and client consent. Advisers Act Rule 206(3)-2 allows an adviser to act as an agent for cross transactions between client accounts without transaction-by-transaction disclosure and consent if: the client has given written authorization after full disclosure of conflicts, the client receives written confirmations that disclose compensation on each transaction, the adviser provides at least annually a disclosure to the client summarizing all agency cross-transactions, and the disclosure documents conspicuously give the client the right to revoke consent at any time.
Advisers Have Fiduciary Duties In addition to Consent and Disclosure Obligations
The SEC warns that an adviser retains fiduciary obligations to clients that may be breached with respect to a principal or agency cross transaction notwithstanding compliance with the disclosure and consent requirements. The substance of an adviser’s disclosure of conflicts of interest to clients is as important as technical compliance with the written consent and disclosure obligations.
OCIE Issues Findings on Common Compliance Issues Involving Principal Trades
OCIE found that some advisers purchased or sold securities for their own accounts from clients without even recognizing the application of Section 206(3) and did not provide disclosure or obtain consent. Some advisers engaged in principal and agency cross-trades and recognized the need for client consent, but the client did not receive sufficient disclosures concerning the adviser’s conflict of interest or the material terms of the transaction.
Compliance Issues Related to Private Funds and Principal Trades
The Risk Alert notes that the SEC is particularly concerned about private funds that an adviser owns equity interests in or manages. This is an area fraught with conflicts that has led to a number of Enforcement actions.2 OCIE noted that advisers have been effecting principal trades between their clients and private funds. If the adviser and its affiliates have a “significant ownership,” which is generally considered to be more than 25 percent of the fund, then Section 206(3) applies. In this case, any transaction effected between the private fund and an advisory client is deemed to be a transaction effected between the client and the adviser and requires disclosure and consent on a transaction-by-transaction basis.
Agency Cross Transaction Compliance Failures
Another key deficiency that OCIE found concerned advisers’ ADV disclosures on agency cross transactions. Some advisers’ Form ADV disclosures indicate that the adviser would not engage in agency cross transactions, but the adviser in fact did engage in such transactions. OCIE also found advisers that claimed compliance with the written consent, confirmation and disclosure requirements for agency cross transactions did not have sufficient, or in some cases any, documentation showing compliance with the rules.
What Advisers Should Do Now
Advisers should immediately review their compliance policies, procedures, and disclosures on principal and agency cross trading. Advisers that engage in principal transactions with clients or effect agency cross-transactions should review their disclosures and consent documentation to make sure they are clearly written and provide for robust disclosure. Advisers and their compliance teams should review the firm’s operations and trading to consider whether these transactions are occurring in compliance with the rules.
Advisers to private funds should pay particular attention to any possible transactions between an advised fund and an advisory client. Advisers need to be mindful of the 25 percent ownership threshold that, once crossed, would trigger treating the fund as an alter ego of the adviser. Finally, to the extent that a private fund has established a conflict committee or other measure to insulate the fund from conflict transactions involving the adviser, the conflict committee should itself be independent of the adviser and free from conflict.
Advisers should pay attention to OCIE Risk Alerts. They are often precursors to Enforcement Division actions where the SEC can comfortably report that they warned you about these items.
[1] See Commission Interpretation of Section 206(3) of the Investment Advisers Act of 1940, Investment Advisers Act Release No. 1732 (July 17, 1988).
[2] See Paradigm Capital Management, Inc. and Candace King Weir, Advisers Act Release No. 3857 (June 2014)(adviser to private fund settled Enforcement action where conflict review committee established to review principal trades was itself conflicted.
